Should You Get a Business Loan?
Written by Adam Hoeksema Tuesday, October 09 2012
A loan can make or break your business. Is your business ready?
Can your business handle a loan? This may seem like a strange question. You might be thinking that you could always use more money. You might say, “certainly a loan wouldn’t hurt my business.” In reality, a loan can kill your business, and your potential lender knows this, so they are going to carefully analyze your financial situation to determine whether or not you can actually afford to borrow money. Here are 3 metrics that your banker will look at closely when you submit your loan application.
1. Global Personal Financial Statement
Most business loan and account receivable lenders like to understand your global financial situation. This means they want to look at your business and personal financial statements added together to determine your ability to pay back the loan. For example, you might start a business while you keep your day job, and the business alone does not generate enough cash flow to make the loan payment each month, but you may have $1,500 left over each month after you pay your personal bills. The lender may be willing to provide a loan to the business based on the global financial position of the owner.
2. Debt Service Coverage Ratio
The debt service coverage ratio is calculated by dividing net operating income by your total debt service. Debt service is simply the dollar amount of all loan payments. Lenders are looking for borrowers that have a debt service coverage ratio of at least 1.25. If your business generates a net income of $100,000 annually, but the new loan you are applying for has a debt service of $100,000 annually, you can’t afford to take out that large of a loan. Your DSCR would be 1, and that leaves absolutely no room for error. Lenders want to see that you have some cushion to make your loan payment even if the business goes through a slow period.
3. Debt to Equity Ratio
This is a simple ratio that the bank is going to look at. Do you have more debt than equity in the business? Generally a ratio of .30 is considered good. That means you have no more than $30 of debt for every $100 of equity. A high debt to equity ratio signals that you probably can’t afford to borrow more money.
Before you jump through all the hoops required by the bank to apply for a business loan, you would be wise to take a look at your personal financial statement, debt service coverage, and your debt to equity ratio. Each time a lender pulls your credit score and does not approve funding, your credit score is negatively impacted, so it is worth your time to do some quick analysis before you ever submit it to the bank.
Adam Hoeksema is the Co-Founder of ProjectionHub. ProjectionHub helps entrepreneurs create financial projections without the need for a PhD in spreadsheet modeling.